What the latest debt crackdown in China means – and doesn’t mean

And it could have big implications for several Chinese sectors – not to mention overall economic growth, for both China and the rest of the world.

You see, in an effort to fuel economic growth over the past few years, China has taken on a lot of debt. Since 2008, China’s debt as a percentage of economic output has increased from around 160 percent to around 280 percent at the end of 2016. (By comparison, the total debt in the U.S. as a percent of economic output is upwards of 300 percent.)

Many think tanks, academics, government officials, and even the (now outgoing) head of the People’s Bank of China, Zhou Xiaochuan, have warned of the risks of China’s debt burden in the Chinese economy.

And now, the government is cracking down on local government debt and online consumer loan platforms.

Why it matters: China is BIG and getting bigger

With a GDP of US$11.2 trillion, China is already the world’s second-largest economy (it will soon be the largest), and it has the second-largest stock market. The country will also soon have the world’s biggest middle class, totalling over 550 million people by 2022. To put this in perspective: That’s 1.7 times the entire population of the U.S.

China is also becoming a leader in globalisation as the U.S. turns inward. Through its One Belt One Road (OBOR) initiative, China is developing infrastructure across 60 countries. China will soon have strategic interests across a huge swathe of Africa, Central Asia and Eastern Europe.

So what happens in China matters – a lot – to the global economy, and to investors everywhere.

How China is reining in debt

It’s also cracking down on local governments taking unsound and illegal debt – mainly through dubious infrastructure projects. That means many local governments will have to postpone or scale down their infrastructure spending plans. For example, since August, the National Development and Reform Commission – the key regulator for infrastructure projects – has cancelled or halted several subway and highway projects for not meeting standards of financial sustainability.

The government is also implementing new measures to reign in online consumer loan platforms.

China’s P2P lending platforms have been rocked by a number of scandals over the past few years, most notably surrounding a platform called Ezubao – which turned out to be a Ponzi scheme and it ripped off nearly a million investors in 2015/16.

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The new regulatory measures haven’t been made public, but they could include suspending new licenses to online micro-loan platforms… telling banks and bank-holding companies not to buy loans underwritten by online platforms because they’re too risky… and forbidding loans from turning into securities.

What’s next?

As a result of these measures, economic growth in China will likely slow.

But following 30 years of around 10 percent GDP growth, and with China becoming more of a middle-income country, it couldn’t possibly sustain those kinds of growth rates. It’s a mathematical certainty.

Inevitably, growth has slowed to around 6-7 percent of GDP recently. Today, growth targets are not as emphatically stated and applied as they were in the past.

While the reality of a slower-growing China took investors a while to get used to, it’s now generally accepted as the most likely outcome for the coming few years.

And what about debt?

One possible outcome is a repeat of what happened in the U.S. between 2007 and 2008. At that time, the U.S. total debt-to-GDP ratio reached 250 percent. Borrowers started defaulting on their loans (especially mortgages) leading to a credit crisis. In the end, several banks failed and others were acquired or had to be bailed out by the government. It all led to a global economic crisis that is still hurting global economic growth.

Another possibility is that it all ends with a whimper instead of a bang. China could lapse into a long period of slow growth or stagnation from its debt load. This would be similar to what Japan has experienced for over two decades (though it’s been looking up a lot in recent months). Not surprisingly, Japan has one of the highest debt-to-GDP ratios in the world. Its government debt-to-GDP ratio at the end of 2015 was 246 percent.

But these are unlikely doomsday scenarios. The Chinese government is focused on the debt issue. It’s not brushing it to the side or pretending that it doesn’t exist (which is how most western governments approached debt in the years leading up to the global economic crisis). That’s encouraging because often, when the Chinese government decides it wants to do something – it gets done. And as we’ve said before, China’s debt is not a reason to stay away from Chinese investments.

In the meantime, we can expect to see the consumption side of the economy continue to grow in importance. China’s massively high savings ratio of around 45 percent of GDP will be drawn down slowly, fueling domestic consumption in all sorts of areas – basic consumer goods, housing, education, healthcare, technology, travel and tourism.

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